Fiscal Policy

How Fiscal Policy Influences Aggregate Demand

The government can influence the behavior of the economy not with monetary policyOpens in new window but also with fiscal policy.

Fiscal policy Opens in new window influences saving, investment, and growth in the long run. In the short run, however, the primary effect of fiscal policy is on the aggregate demand for goods and services.

Changes in Government Purchases

Suppose, for instance, that the U.S. Department of Defense places a $20 billion order for new fighter planes with Boeing Opens in new window, the large aircraft manufacturer. This order raises the demand for the output produced by Boeing, which induces the company to hire more workers and increase production.

Because Boeing is part of the economy Opens in new window, the increase in the demand for Boeing planes means an increase in the total quantity of goods and services demanded at each price level. As a result, the aggregate-demand curve shifts to the right.

At first, one might guess that the aggregate-demand curve shifts to the right by exactly $20 billion. It turns out, however, that this is not the case.

There are two macroeconomic effects that cause the size of the shift in aggregate demand to suffer from the change in government purchases.

We now discuss these two effects in turn.

The Multiplier Effect

When the government buys $20 billion of goods from Boeing, that purchase has repercussions. The immediate impact of the higher demand from the government is to raise employment and profits at Boeing.

Then, as the workers see higher earnings and the firm owners see higher profits, they respond to this increase in income by raising their own spending on consumer goods. As a result, the government purchase from Boeing raises the demand for the products of many other firms in the economy.

This multiplier effect continues even after this first round. When consumer spending rises, the firms that produce these consumer goods hire more people and experience higher profits. Higher earnings and profits stimulate consumer spending once again and so on.

Thus, there is positive feedback as higher demand leads to higher income, which in turn leads to even higher demand. Once all these effects are added together, the total impact on the quantity of goods and services demanded can be much larger than the initial impulse from higher government spending.

Figure IV illustrates the multiplier effect. The increase in government purchases of $20 billion initially shifts the aggregate-demand curve to the right from AD₁ to AD₂ by exactly $20 billion. But when consumers respond by increasing their spending, the aggregate-demand curve shifts still further to AD₃.

Figure IV, The Multiplier Effect | Source: Slideshare Opens in new window

This multiplier effect arising from the response of consumer spending can be strengthened by the response of investment to higher levels of demand. For instance, Boeing might respond to the higher demand for planes by deciding to buy more equipment or build another plant.

In this case, higher government demand spurs higher demand for investment goods. This positive feedback from demand to investment is sometimes called the investment accelerator.

A Formula for the Spending Multiplier

Some simple algebra permits us to derive a formula for the size of the multiplier effect that arises when an increase in government purchases induces increases in consumer spending.

An important number in this formula is the marginal propensity to consume (MPC) — the fraction of extra income that a household consumers rather than saves. For example, suppose that the marginal propensity to consume is ³/₄.

This means that for every extra dollar that a household earns, the household spends $0.75 (³/₄ of the dollar) and saves $0.25.

With an MPC of ³/₄, when the workers and owners of Boeing earn $20 billion from the government contract, they increase their consumer spending by ³/₄ x $20 billion, or $15 billion.

To gauge the impact on aggregate demand of a change in government purchases, we follow the effects step-by-step. The process begins when the government spends $20 billion, which implies that national income (earnings and profits) also rises by this amount.

This increase in income in turn raises consumer spending by MPC x $20 billion, which raises the income for the workers and owners of the firms that produce the consumption goods. This second increase in income again raises consumer spending, this time by MPC x $20 billion). These feedback effects go on and on.

To find the total impact on the demand for goods and services, we add up all these effects:

Here “. . .” represents an infinite number of similar terms. Thus, we can write the multiplier as follows:

Multiplier = 1 + MPC + MPC² + MPC³ + …

This multiplier tells us the demand for goods and services that each dollar of government purchases generates. To simplify this equation for the multiplier, recall from math class that this expression is an infinite geometric series. For 𝑥 between – 1 and + 1,

1 + 𝑥 + 𝑥² + 𝑥³ + . . . = 1/(1 – 𝑥).

In our case, 𝑥 = MPC. Thus,

Multiplier = 1/(1 – MPC).

For example, if MPC is ³/₄, the multiplier is 1/(1 - ³/₄), which is 4. In this case, the $20 billion of government spending generates $80 billion of demand for goods and services.

This formula for the multiplier shows that the size of the multiplier depends on the marginal propensity to consume. While an MPC of ³/₄ leads to a multiplier of 4, and MPC of ¹/₂ leads to a multiplier of only 2. Thus, a larger MPC means a larger multiplier.

To see why this is true, remember that the multiplier arises because higher income induces greater spending on consumption. With a larger MPC, consumption responds more to a change in income, and so the multiplier is larger.

Other Applications of the Multiplier Effect

Because of the multiplier effect, a dollar of government purchases can generate more than a dollar of aggregate demand. The logic of the multiplier effect, however, is not restricted to changes in government purchases. Instead, it applies to any event that alters spending on any component of GDP – consumption, investment, government purchases, or net exports.

For example, suppose that a recession overseas reduces the demand for U.S. net exports by $10 billion. This reduced spending on U.S. goods and services depresses U.S. national income, which reduces spending by U.S. consumers. If the marginal propensity to consume is ³/₄ and the multiplier is 4, then the $10 billion fall in net exports leads to a $40 billion contraction in aggregate demand.

As another example, suppose that a stock market boom increases households’ wealth and stimulates their spending on goods and services by $20 billion. This extra consumer spending increases national income, which in turn generates even more consumer spending. If the marginal propensity to consume is ³/₄ and the multiplier is 4, then the initial impulse of $20 billion in consumer spending translates into an $80 billion increase in aggregate demand.

The multiplier is an important concept in macroeconomics because it shows how the economy can amplify the impact of changes in spending. A small initial change in consumption, investment, government purchases, or net exports can end up having a large effect on aggregate demand and, therefore, the economy’s production of goods and services.

The Crowding-Out Effect

The multiplier effect Opens in new window seems to suggest that when the government buys $20 billion of planes from Boeing, the resulting expansion in aggregate demand is necessarily larger than $20 billion. Yet another effect works in the opposite direction.

While an increase in government purchases stimulates the aggregate demand for goods and services, it also causes the interest rate to rise, reducing investment spending and putting downward pressure on aggregate demand. The reduction in aggregate demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect.

To see why crowding out occurs, let’s consider what happens in the money market when the government buys planes from Boeing. As we have discussed, this increase in demand raises the incomes of the workers and owners of this firm (and, because of the multiplier effect, of other firms as well).

As income rise, households plan to buy more goods and services and, as a result, choose to hold more of their wealth in liquid form. That is, the increase in income caused by the fiscal expansion raises the demand for money.

The effect of the increase in money demand is shown in panel (a) of Figure V.

Figure V, The Crowding-Out Effect | Source: SlideToDoc Opens in new window

Panel (a) shows the money market. When the government increases its purchases of goods and services, income increases, raising the demand for money from MD1 to MD2 and thereby increasing the equilibrium interest rate from r1 to r2. Panel (b) shows the effects on aggregate demand. The initial impact of the increase in government purchases shifts the aggregate-demand curve from AD1 to AD2. Yet because the interest rate is the cost of borrowing, the increase in the interest rate tends to reduce the quantity of goods and services demanded, particularly for investment goods. This crowding out of investment partially offsets the impact of the fiscal expansion on aggregate demand. In the end, the aggregate-demand curve shifts only to AD3.

Because the Fed has not changed the money supply, the vertical supply curve remains the same. When the higher level of income shifts the money demand curve to the right from MD₁ to MD₂, the interest rate must rise from r₁ to r₂ to keep supply and demand in balance.

The increase in the interest rate, in turn, reduces the quantity of goods and services demanded. In particular, because borrowing is more expensive, the demand for residential and business investment goods declines.

In other words, as the increase in government purchases increases the demand for goods and services, it may also crowd out investment.

This crowding-out effect partially offsets the impact of government purchases on aggregate demand, as illustrated in panel (b) of Figure 5. The increase in government purchases initially shifts the aggregate-demand curve from AD₁ to AD₂, but once crowding out takes place, the aggregate-demand curve drops back to AD₃.

The multiplier effect makes the shift in aggregate demand greater than $20 billion. The crowding-out effect pushes the aggregate-demand curve in the opposite direction and can, if large enough, result in an aggregate-demand shift of less than $20 billion.

Changes in Taxes

In addition to the multiplier and crowding-out effects, there is another important determinant of the size of the shift in aggregate demand that results from a tax change: households’ perceptions about whether the tax change is permanent or temporary.

For example, suppose that the government announces a tax cut of $1,000 per household. In deciding how much of this $1,000 to spend, households must ask themselves how long this extra income will last.

An extreme example of a temporary tax cut was the one announced in 1992. In that year, President George H. W. Bush faced a lingering recession and an upcoming reelection campaign. He responded to these circumstances by announcing a reduction in the amount of income tax that the federal government was withholding from workers’ paychecks.

Because legislated income tax rates did not change, however, every dollar of reduced withholding in 1992 meant an extra dollar of taxes due on April 15, 1993, when income tax returns for 1992 were to be filed. Thus, this “tax cut” actually represented only a short-term loan from the government. Not surprisingly, the impact of the policy on consumer spending and aggregate demand was relatively small.